A model of (in)efficiency in NPE litigation

In-house counsel have long known that non-practicing entity (NPE) litigation is expensive, and we’ve always believed that the process is maddeningly wasteful and inefficient. Exactly how expensive and inefficient, however, has been difficult to pinpoint because there’s been an utter lack of data and no accurate way to quantify the waste of NPE assertions in dollar terms.

Until now.

As I’ve discussed in previous columns, RPX has been building a growing database covering patent transactions and activity, including a broad cross-section of detailed litigation cost information. The data shows, across thousands of cases, how defense counsel, plaintiff counsel, NPEs and patent owners capture the costs of NPE litigation. Using this information, I’ll give a simple illustration to show just where the money is going in a typical NPE litigation.

In this example—which, by the way, is closely based on a monetization campaign outlined in an offering memorandum by a fund-raising NPE—the portfolio would be monetized on a contingency basis, meaning the owner of the patents would receive payment only after costs were taken out of the settlement. The portfolio was thought to have broad applicability and the NPE had targeted 40 operating companies as alleged infringers.

The average settlement in the campaign was expected to be $1 million per defendant company, producing $40 million in revenue (the bottom half of the bar chart) and we know from RPX data that on average, each company would also spend an average of $1 million to defend against the suit, producing $40 million in total legal costs (the top half of the bar).

Already this looks like a very inefficient way to transfer economic value, as the legal transaction costs are equal to the license value of the asset. In truth, it is even more economically irrational than this because the settlement itself is reduced by further transaction costs on the plaintiff’s side.

In this example, $32 million of the $40 million settlement was expected to be spent on various plaintiff’s counsel, experts and legal support, or delivered to the NPE and its investors. After these costs, there would only be a net of $8 million remaining for the owner of the portfolio.

In other words, to generate an $8 million payment for the inventor/owner of the patent, this campaign would incur a total of $72 million in frictional costs—a roughly 900 percent transaction cost. This is quantifiable waste on a monumental scale, and it proves that the intuition of in-house counsel has been entirely accurate.

The central problem, of course, is the inherent high cost and inefficiency of the legal system. In a functioning market ecosystem, the payment from the “users” of the patent to the owner would have far fewer intermediaries (who charge far less per hour) and a much more transparent form of price discovery than legal due diligence and court proceedings. There would be comparables, ready access to data, and values would more accurately reflect the value of the invention rather than the hold-up costs of litigation.

For general counsel balancing their legal and fiduciary responsibilities as corporate officers, the answer is clear. While aggressive legal defense against NPE assertion is at times warranted and indeed necessary, it is far more efficient for those 40 defendants to work together to proactively buy the patent from the owner before litigation occurs. Rather than pay $2 million each, those 40 defendants could have paid $200,000 each and provided the same return to the patent owner. In other words, head off the problem before it starts and before those 900 percent transaction costs artificially inflate the amount paid by the defendants for the asset.